How do the stock market and the economy work? | Oliver Elfenbaum and Richard M. Coffin

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4:02So many of us have a fake it till you make it relationship when it comes to understanding how money works. We've cobbled together financial wisdom from our lived experience, the advice we get from our family and friends, whatever snippets we read about or hear about on the news. That's most of us. Trust me, I get it. And I've been there. But that's exactly why it never hurts to have a little refresher on the fundamentals.

4:32I'm Madupa Akinola. This is TED Business, a podcast from TED. If you need a quick primer on how our markets function, our friends at TED-Ed have got you covered. These three lessons provide the answers to three big-picture questions. How does the stock market work? How do investors choose their stocks? And what causes an economic recession? Then after the talk, I'll discuss why a brush-up never hurts. But first, a quick break.

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7:11And now, three lessons from Ted Ed. In the 1600s, the Dutch East India Company employed hundreds of ships to trade gold, porcelain, spices, and silks around the globe. But running this massive operation wasn't cheap. In order to fund their expensive voyages, the company turned to private citizens, individuals who could invest money to support the trip in exchange for a share of the ship's profits. This practice allowed the company to afford even grander voyages, increasing profits for both themselves and their savvy investors. Selling these shares in coffeehouses and shipping ports across the continent, the Dutch East India Company unknowingly invented the world's first stock market.

8:00Since then, companies have been collecting funds from willing investors to support all kinds of businesses. And today, the stock market has schools, careers, and even whole television channels dedicated to understanding it. But the modern stock market is significantly more complicated than its original incarnation. So how do companies and investors use the market today? Let's imagine a new coffee company that decides to launch on the market. First, the company will advertise itself to big investors. If they think the company is a good idea, they get the first crack at investing and then sponsor the company's initial public offering, or IPO.

8:41This launches the company onto the official public market, where any company or individual who believes the business could be profitable might buy a stock. Buying stocks makes those investors partial owners in the business. Their investment helps the company to grow, and as it becomes more successful, more buyers may see potential and start buying stocks. As demand for those stocks increases, so does their price, increasing the cost for prospective buyers and raising the value of the company's stocks people already own. For the company, this increased interest helps fund new initiatives and also boosts its overall market value by showing how many people are willing to invest in their idea.

9:24However, if for some reason a company starts to seem less profitable, the reverse can also happen. If investors think their stock value is going to decline, they'll sell their stocks with the hopes of making a profit before the company loses more value. As stocks are sold and demand for the stock goes down, the stock price falls, and with it, the company's market value. This can leave investors with big losses, unless the company starts to look profitable again. This seesaw of supply and demand is influenced by many factors. Companies are under the unavoidable influence of market forces, such as the fluctuating price of materials, changes in production technology, and the shifting costs of labor.

10:06Investors may be worried about changes in leadership, bad publicity, or larger factors like new laws and trade policies. And of course, plenty of investors are simply ready to sell valuable stocks and pursue personal interests. All these variables cause day-to-day noise in the market, which can make companies appear more or less successful. And in the stock market, appearing to lose value often leads to losing investors, and in turn, losing actual value. Human confidence in the market has the power to trigger everything from economic booms to financial crises. And this difficult-to-track variable is why most professionals promote reliable long-term investing over trying to make quick cash.

10:49However, experts are constantly building tools in efforts to increase their chances of success in this highly unpredictable system. But the stock market is not just for the rich and powerful. With the dawn of the internet, everyday investors can buy stocks in many of the exact same ways a large investor would. And as more people educate themselves about this complex system, they too can trade stocks, support the businesses they believe in, and pursue their financial goals. The first step is getting invested.

11:23Every day, billions of stocks are traded on the New York Stock Exchange alone. But with over 43 ,000 companies listed on stock exchanges around the world, how do investors decide which stocks to buy? To answer this question, it's important to first understand what stocks are and what individuals and institutions hope to achieve by investing in them. Stocks are partial shares of ownership in a company. So by buying a stock, investors buy a share in the company's success or failure as measured by the company's profits. A stock's price is determined by the number of buyers and sellers trading it.

12:05If there are more buyers than sellers, the price will increase, and vice versa. The market price of a share, therefore, represents what buyers and sellers believe the stock and, by association, the company is worth. So the price can change dramatically based on whether investors think the company has a high potential for increasing profitability. even if it isn't profitable yet. Investors aim to make money by purchasing stocks whose value will increase over time. Some investors aim simply to grow their money at a faster rate than inflation diminishes its value. Others have a goal of beating the market, which means growing their money at a faster rate than the cumulative performance of all companies' stocks.

12:51This idea of beating the market is a source of debate among investors. In fact, investors break into two main groups over it. Active investors believe it is possible to beat the market by strategically selecting specific stocks and timing their trades, while passive investors believe it isn't usually possible to beat the market and don't subscribe to stock picking. The phrase beating the market usually refers to earning a return on an investment that exceeds the Standard & Poor 500 Index, The S &P 500 is a measure of the average performance of 500 of the largest companies in the United States, weighted by company valuation, meaning that companies with a higher market value have a larger effect on the S &P.

13:39Again, market value corresponds to what investors believe a company is worth, rather than actual profits. The S &P doesn't directly represent the market as a whole. many small and mid-range stocks can fluctuate according to different patterns. Still, it's a pretty good proxy for the overall market. It's often said that the stock market behaves like a voting machine in the short term and a weighing machine in the long term, meaning short-term fluctuations in stock prices reflect public opinion. But over the longer term, they do tend to actually reflect companies' profits. Active investors aim to exploit the short-term, voting machine aspect of the market.

14:23They believe the market contains inefficiencies, that stock prices at any given point in time may overvalue some companies, undervalue others, or fail to reflect developments that will impact the market. Active investors hope to exploit these inefficiencies by buying stocks they think are priced low. To identify undervalued stocks, they may investigate a company's business operations, analyze its financial statements, observe price trends, or use algorithms. Passive investors, by contrast, put their faith in the long-term weighing machine aspect of the market. They believe that even though markets may exhibit inefficiencies at any given point, over time those inefficiencies balance out.

15:09So if they buy a selection of stocks that that represents a cross-section of the market, over time it will grow. This is usually accomplished through index funds, collections of stocks that represent the broader market. The S &P 500 index is one of many indexes. The overall goal is the same for all index funds, to hold stocks for the long term and ignore short-term market fluctuations. Ultimately, active and passive investing aren't mutually exclusive. Many investment strategies have elements of each. For example, choosing stocks actively, but holding them for the long term as passive investing advises.

15:50Investing is far from an exact science. If there was one foolproof method, everyone would be doing it.

16:01For millennia, the people of Britain had been using bronze to make tools and jewelry, and as a currency for trade. But around 800 BCE, that began to change. The value of bronze declined, causing social upheaval and an economic crisis, what we would call a recession today. What causes recessions? This question has long been the subject of heated debate among economists, and for good reason. A recession can be a mild decline in economic activity in a single country that lasts months, a long-lasting downturn with global ramifications that lasts years, or anything in between. Complicating matters further, there are countless variables that contribute to an economy's health, making it difficult to pinpoint specific causes.

16:54So it helps to start with the big picture. Recessions occur when there is a negative disruption to the balance between supply and demand. There's a mismatch between how many goods people want to buy, how many products and services producers can offer and the price of the goods and services sold, which prompts an economic decline. An economy's relationship between supply and demand is reflected in its inflation rates and interest rates. Inflation happens when goods and services get more expensive. Put another way, the value of money decreases. Still, inflation isn't necessarily a bad thing. In fact, a low inflation rate is thought to encourage economic activity.

17:39But high inflation that isn't accompanied with high demand can both cause problems for an economy and eventually lead to a recession. Interest rates, meanwhile, reflect the cost of taking on debt for individuals and companies. The rate is typically an annual percentage of a loan that borrowers pay to their creditors until the loan is repaid. Low interest rates mean that companies can afford to borrow more money, which they can use to invest in more projects. High interest rates, meanwhile, increase costs for producers and consumers, slowing economic activity. Fluctuations in inflation and interest rates can give us insight into the health of the economy.

18:20But what causes these fluctuations in the first place? The most obvious causes are shocks like natural disaster, war, and geopolitical factors. An earthquake, for example, can destroy the infrastructure needed to produce important commodities, such as oil. That forces the supply side of the economy to charge more for products that use oil, discouraging demand and potentially prompting a recession. But some recessions occur in times of economic prosperity, possibly even because of economic prosperity. Some economists believe that business activity from a market's expansion can occasionally reach an unsustainable level.

19:02For example, corporations and consumers may borrow more money with the assumption that economic growth will help them handle the added burden. But if the economy doesn't grow as quickly as expected, they may end up with more debt than they can manage. To pay it off, they'll have to redirect funds from other activities, reducing business activity. Psychology can also contribute to a recession. Fear of a recession can become a self-fulfilling prophecy if it causes people to pull back investing and spending. In response, producers might cut operating costs to help weather the expected decline in demand.

19:40That can lead to a vicious cycle, as cost cuts eventually lower wages, leading to even lower demand. Even policy designed to help prevent recessions can contribute. When times are tough, governments and central banks may print money, increase spending, and lower central bank interest rates. Smaller lenders can in turn lower their interest rates, effectively making debt cheaper to boost spending. But these policies are not sustainable and eventually need to be reversed to prevent excessive inflation. That can cause a recession if people have become too reliant on cheap debt and government stimulus.

20:19The Bronze Recession in Britain eventually ended when the adoption of iron helped revolutionize farming and food production. Modern markets are more complex, making today's recessions far more difficult to navigate. But each recession provides new data to help anticipate and respond to future recessions more effectively.

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23:02Look, I have an MBA. I work in corporate spaces. I teach at a business school for goodness sake. And yet I always appreciate these refreshers. I didn't grow up in a household where we talked about the ins and outs of the stock market. I remember being younger and at the beginning of my financial journey, asking my peers and my teachers, wait, explain that to me again? I understand. It feels awkward in the moment, but trust me on this. Just ask the question. You'll get the answers you're looking for. And I bet you other people in the room were wondering the same thing too. You never know who else you're helping out by Speaking Up.

23:42We've done a lot of episodes on this show with leading experts who say that the people who are most effective in their jobs are ones who aren't afraid to ask the obvious questions. Remember when Molly Graham said that one of her greatest strengths is that she feels comfortable sounding like a moron? And if you do still feel uncomfortable asking some basic questions about how money and our markets work, our friends at TED-Ed have a vast library of lessons up for free on the TED-Ed website, tackling topics like why aren't airplanes getting faster and why can't we just print off money to pay off debt?

24:22If you've dreamt up a question, they've probably thought up an answer and it's waiting for you there. Don't worry, we've got your back. That's it for today. TED Business is part of the TED Audio Collective. This episode was produced by Hannah Kingsley-Ma, edited by Alejandra Salazar, and fact-checked by Julia Dickerson. Special thanks to Maria Ladias, Farrah DeGrange, Daniela Balarezo, Tansika Sangmanibong, and Roxanne Hilash. I'm Madupa Akinola. Thanks for listening.

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